Macro and Credit - Klondike

"Having patience is one of the hardest things about being human. We want to do it now, and we don't want to wait. Sometimes we miss out on our blessing when we rush things and do it on our own time." -  Deontay Wilder

Looking at the latest FOMC decision, leading to further compression of US yields in conjunction with rising negative yielding bonds to the tune of $12.3 trillion, making credit and high beta risky assets TINA (There Is No Alternative) again, when it came to selecting our title analogy, we decided to continue with the theme of games and playing cards this time around. Klondike (North America) or Canfield (traditional) is a patience game (solitaire card game). In the U.S. and Canada, Klondike is the best-known solitaire card game, to the point that the term "solitaire", in the absence of additional qualifiers, typically refers to Klondike. Elsewhere the game is known as American Patience. 

The game rose to fame in the late 19th century, being named "Klondike" after the Canadian region where a gold rush happened. With the FOMC (Federal Open Market Committee) holding interest rates steady on Wednesday while opening the door to a cut by dropping its commitment to being "patient" in its policy statement, in similar fashion to the name of the card game of Klondike also known as "patience", the Fed conceded to more accommodation to come in July in the form of a rate cut. No wonder it led in similar fashion to a "Klondike" leading yet to another "gold rush" it seems as anticipated somewhat in our previous musing. What we find of interest in the game of "Klondike" played by the Fed is that from a probability perspective, about 79% of the games are theoretically winnable, but in practice, human players do not win 79% of games played, due to wrong moves that cause the game to become unwinnable. In addition to this probabilistic feature, some games are "unplayable" in which no cards can be moved to the foundations even at the start of the game; these occur in only 0.25% (1 in 400) of hands dealt. 

Also, there is a modified version of the game called "Thoughtful Solitaire", in which the identity of all 52 cards is known. Because the only difference between the two games (Klondike and Thoughtful) is the knowledge of card location, all "Thoughtful" games with solutions will also have solutions in "Klondike". Similarly, all dead-ends in "Thoughtful" will be dead ends in "Klondike". However, the theoretical odds of winning a standard game of "non-Thoughtful Klondike" are currently not known exactly. The inability of theoreticians to precisely calculate these odds has been referred to by mathematician Persi Diaconis as "one of the embarrassments of applied probability but we ramble again...

In this week's conversation, we would like to look at what the latest Fed decision entails as we think that we are on the cusp of a final melt-up which could be given an additional boost from some cease-fire agreement between China and the United States when it comes to the lingering trade war.

Synopsis:

• Macro and Credit - Is the Fed ready for "easing" after being "easy"?
• Final charts - Fed "easing" should undermine the US dollar.

• Macro and Credit - Is the Fed ready for "easing" after being "easy"?

Given the global "dovishness" now being actively espoused globally and with the Fed conceding to what the financial markets want, we view a continuation of the "Japanification" playing out, meaning that credit spreads will continue to perform and compress, and the corporate debt bubble to inflate in this Chinese year of the pig. The appetite for yield hungry investors will continue to push even more government bonds yields to absurd level and even more European corporate yields into negative territory. 

From an allocation perspective, as we pointed out before, where oil price goes, so does US High Yield, clearly since the beginning of the year US Investment Grade has outperformed US High Yield, respectively up 10% and 9%. Our defensive stance favoring quality (Investment Grade) over quantity (US High Yield has been vindicated. As well our preference for the long-end of the US yield curve is paying decently with long-term US Treasuries ($TLT) up by 11%. Year to date the ETF ZROZ we follow is up by a decent 14.4%. Gold is rising again in a very much "Klondike" way with gold miners racing ahead thanks to the return of the "D" word of "Deflation" and "D" for "Dovishness".

As we highlighted in our most recent musing, weak dollar policy is a natural extension of protectionist policies. FX policy should not be ignored in trade policy. They go hand in hand as a reminder. The trajectory of real yields matter when it comes to gold:

"The ongoing trade war could turn into a currency war, further boosting investor appetite for gold hence our negative stance on the US dollar." - source Macronomics, June 2019

We also added:

"If big dollar cycles are dominated by flow as indicated by Deutsche Bank, then again, the dovish Fed has finally triggered a USD sell-off it seems with hedge funds selling from a long position. If flows are indeed turning against the USD, then a US dollar weakness could be sustained." - source Macronomics, June 2019

Given the latest tone down from the Fed with rate cut expectations in July, and a possible form of resolution between the United States and China with the upcoming G20, there is indeed a potential for an additional melt-up, and in this scenario, high beta would therefore start to outperform again strongly.

A weaker US dollar is as well highly beneficial to the Emerging Markets complex. Should you therefore "buy" the proverbial dip? Obviously credit continues to benefit from "Bondzilla" the NIRP monster close to $13 trillion. In that context yield hunt will resume its trajectory.

When it comes to the much discussed "leveraged loans" we continue to see the "great rotation" playing out from the feeble hands of retail, namely them leaving the asset class and investing into US High Yield. This is clearly indicated by LeveragedLoan.com part of S&P Global Market Intelligence:

"Outflows from mutual funds and ETFs that invest in U.S. leveraged loans totaled $686 million for the week ended June 12, according to Lipper weekly reporters. That's less severe than the $1.47 billion withdrawal a week ago, but marks the 30th straight net outflow from the investor segment, for a total of slightly more than $30 billion over that span.

Retail investors have beat a steady retreat from the floating rate asset class as prospects of a Fed rate hike have evaporated, and as expectations of rate hikes solidify.

The record for consecutive withdrawals from U.S. loan funds is 32 weeks, for a streak that ended March 2, 2016, though outflows during that time totaled only $17.6 billion, according to Lipper.

Mutual funds provided the bulk of the outflow over the past week, at $572 million, while loan ETFs saw a withdrawal of $114 million. The four-week average is now a net $781 million outflow. The change due to market conditions over the past week was positive $56 million.

Year to date, including the week ended Jan. 2, outflows from the segment now total $16.5 billion. Assets at U.S. loan funds stand at $78.6 billion, of which $8.2 billion are via ETFs, according to Lipper." - source S&P Market Intelligence

At the same time, the feeble retail investors crowd did put $602M into US High Yield funds, the second straight week of inflows. YTD: +$8.9B $HYG $JNK according to S&P Market Intelligence:

 - source S&P Market Intelligence

With the market now pricing in a 100% probability of a rate cut in July, from a "Klondike" perspective, we do think there is a potential for more melt-up in the high beta space.

So what's our current view on the US 10 year yield you might rightly ask?

As a reminder, when it comes to our contrarian stance in relation to our "long duration" exposure it is fairly simple to explain:

"Government bonds are always correlated to nominal GDP growth, regardless if you look at it using "old GDP data" or "new GDP data". So, if indeed GDP growth will continue to lag, then you should not expect yields to rise anytime soon making our US long bonds exposure still compelling regardless of what some sell-side pundits are telling you." - Macronomics, December 2015, The Ghost of Christmas Past

So if indeed US GDP growth is decelerating, then, obviously the US 10 year yield is right where it should be given FOMC change in real GDP for 2019 is around 2.1%. Case closed.

Giving the global dovishness from our "generous gamblers" aka our dear central bankers, when it comes to this game of Klondike and asset implications we read with interest UBS take from their Global Macro Strategy note from the 20th of June entitled "Fed, ECB Promise Insurance: Asset Implications":

"Rates: Lower long end real; front end sits oddly with financial conditions

The market has celebrated the readiness from the Fed to provide insurance and bull steepened the curve. Compared with the beginning easing cycles over the last 30 years, inflation is marginally lower today, but financial conditions are significantly looser (Figure 1).

Our Economic team's view is now for a 50bps cut in July, (64% priced), which may take some deterioration in financial conditions to be fully priced. Based on the current information, and with 76 bps already priced till year end, we would not be receiving the very front end here, and would rather position through long 5-year breakevens and receiving long-end real rates. The Fed Chair cited concerns over fall in 5y5y breakevens several times as a reason for the material shift lower in dots." - source UBS

 What is indeed striking to use as we mused in our previous conversation is that financial conditions, while tightening already in some parts are not as tight as in previous cycles as highlighted by UBS table above. This is what we had to say in our previous conversation:

"Taking it easy is not taking it to easing and as per our above discussion we think investors are a little bit ahead of themselves when it comes to the number of cuts expected and the pace. One nonfarm payroll bad number doesn't yet make a trend though the most recent data highlights disappointment and worries from the ongoing trade war." - source Macronomics, June 2019

Though we were steering towards a more cautious side, given flash U.S. Composite Output Index just came out 50.6 (50.9 in May), a 40-month low, we would not dare to "fight" the Fed and we'd rather probably switch slightly to "offense" from "defense". Credit wise, European Investment Grade remains unattractive with European yield at 0.55% (Barclays EuroAgg Corporate ISMA Yield). So all in all, we'd rather stick with US Investment Grade than European Investment Grade. In Europe we prefer European High Yield in that context. As far as US High Yield is concerned, just follow oil prices.

For the "perma bear" out there, it's the velocity of oil prices that matter on the way up as well as on the way down when it comes to "high beta". We still think that eventually the spark of a "crash" will be ignited by a sudden spike in inflation à la 2008. We are not there yet, and on that front, it could come from a "geopolitical exogenous" factor.

Clearly as highlighted by Société Générale in their 20th of June report "On Our Minds" entitled "The Fed loses patience and ready to act", the game of Klondike comes to mind:

"Summary: The Fed lost patience in June. Dropping this key word and announcing they will closely monitor incoming information strongly suggests rate cuts. Timing and magnitude are the questions. We see two cuts in 2019 matching a heavy weighting of the dots offered in the June Summary of Economic Projections.

Median held in 2019—but large mass of dots imply two rate cuts

The Fed announced they are monitoring information closely. They dropped their reference to patience. The news implies they are at willing to make insurance cuts to keep the expansion intact. The first cut likely at the next FOMC meeting in July.

FOMC revises up GDP and lowers the unemployment projections

The US growth outlook alone does not immediately justify rate cuts, but with inflation low and risks and uncertainty increasing, Fed officials appear willing to make one to two cuts.

Insurance cuts that the Fed foresees pulling back eventually

The Fed median does not fully grasp the number of Fed officials willing to cut by 50bps. Cuts are likely sooner than the median implies Yet hikes into 2021 imply the Fed will pull back these insurance cuts. The Fed does not yet appear back a full rate cut cycle.

Fed insurance cuts vs full rate-cut cycle

The Fed dot plot assumes one to two cuts and then rates are held steady and eventually hiked again. This would follow a pattern more akin to insurance cuts that achieve a soft landing.

Markets are priced for more. Eventually we view the US economic situation as requiring more. We now foresee the Fed following up with insurance cuts in 2019 and highlight July and September for the moves that reduce the fed funds rate by 25 bps each. The magnitude and timing remain sensitive to the G20 meetings and trade talks between the US and China. Additionally, incoming US data with strong US consumers and still solid employment influence timing.

We still see a need for more aggressive rate cuts eventually as sigs of US economic weakness are more pronounced. US manufacturing is currently soft, but that may be needed to reduce inventory overhang. US consumption and employment remain solid for now. Our preliminary call for June non-farm payrolls is for a 175k increase. We still have 3.6% unemployment rate, but that rate can still drop further due to the pace of hiring.

The FOMC revised up its GDP estimate for 2020! Further, the FOMC reduced their unemployment rate projections. These projections do not reflect major risks. Rather it is the low inflation rate along with risks that allow the Fed to make insurance cuts.

Low inflation – the Fed lowered their headline and core inflation readings for 2020, is a major driver in the Fed’s willingness to cut rates. Fed officials foresee uncertainty, global sluggishness and a stronger dollar as over-riding domestic labor markets in shaping the outlook on inflation." - source Société Générale.

Given in the game of Klondike the issue is that a wrong move cannot be known in advance whenever more than one move is possible, we remain agnostic about how aggressive the Fed will be as it has clearly shown us to be "data dependent". Is the recent weakness transitory and mostly due to the trade war narrative being extended into overtime? We wonder.

For our final chart, the big known unknown remains the trajectory of the US dollar. We continue to think though there is more weakness ahead.

• Final charts - Fed "easing" should undermine the US dollar.

Our final chart below comes from Deutsche Bank FX Special Report from the 18th of June and entitled "A unique Beast". It displays the trajectory of the US dollar surrounding Fed easing cycles:

"The FX market. 

In the 3m after easing the dollar TWI tends to continue the pre-easing trend (up or down!) rather than automatically start weakening. In this cycle unique features include: i) low/negative rates elsewhere; and, ii) the unusual US rate-spread advantage across short and back-end yields. It will then take multiple Fed rate cuts to undermine the USD’s rate advantage, generating even more USD resilience than usual.

Fed easing will undermine the dollar's upside on a TWI basis, but the central bank will have to deliver more than the 50bps of cuts by Dec meeting to kick start EUR/ USD meaningfully higher.

Momentum trading has had a record of doing poorly in easing cycles.

Value currency investing does better especially a year after easing cycles begin.

This favors short base metals – long precious metals." - source Deutsche Bank

From a "Klondike" perspective and an additional "gold" rush, it remains to be seen how aggressive the Fed will be in July. While we do expect at least some short-term pull-back on gold prices, it really depends if the Fed decides to throw early in the kitchen sink and the trajectory of "real yields (Gibson's paradox) and obviously the G20 outcome surrounding the US-China tug of war. American patience is, it seems, the name of the game...

"Just be patient. Let the game come to you. Don't rush. Be quick, but don't hurry." - Earl Monroe

Stay tuned !

Macro and Credit - The Clemency of Titus

"Clemency is the noblest trait which can reveal a true monarch to the world." - Pierre Corneille

Watching with interest France getting a onetime exemption for its swelling budget deficit for 2019 with France now expecting a budget deficit of 3.2% of GDP (it will be higher rest assured...), whereas Italy in recent days has offered to target a budget deficit of 2%, when it came to selecting our title analogy for our first post for 2019, we decided to go for a musical one, Mozart's 1791 opera entitled "The Clemency of Titus". 

In 1791, the last year of his life, Mozart was already well advanced in writing Die Zauberflöte by July when he was asked to compose an opera seria. The commission came from the impresario Domenico Guardasoni, who lived in Prague and who had been charged by the Estates of Bohemia with providing a new work to celebrate the coronation of Leopold II, Holy Roman Emperor, as King of Bohemia. The coronation had been planned by the Estates in order to ratify a political agreement between Leopold and the nobility of Bohemia (it had rescinded efforts of Leopold's brother Joseph II to initiate a program to free the serfs of Bohemia and increase the tax burden of aristocratic landholders). Leopold desired to pacify the Bohemian nobility in order to forestall revolt and strengthen his empire in the face of political challenges engendered by the French Revolution. No opera of Mozart was more clearly pressed into the service of a political agenda than "La clemenza di Tito" (The Clemency of Titus), in this case to promote the reactionary political and social policies of an aristocratic elite. No evidence exists to evaluate Mozart's attitude toward this, or even whether he was aware of the internal political conflicts raging in the kingdom of Bohemia in 1791. 

In similar fashion, we think that the European Commission's one off "clemency" in relation to France's budget deficit trajectory comes from a desire to "pacify" and "forestall" revolt and maintain the European "empire" in the face of upcoming European elections and political challenges. These challenges have been increasing at a rapid pace in 2018 with the rise of their nemesis aka "populism" but, we ramble again...

In this first post of the year, we would like to look at the continuation of "risk-off" and what it entails. We have been pretty clear about the need to reduce your high beta exposure credit wise in the light of additional weakness in oil prices affecting dearly the US High Yield CCC bucket. Also, we did advise you to raise your cash levels to start playing defense and we were lucky enough to spot the peak in US equities in our first October conversation "The Armstrong limit". The rest, as we say, is history...But, as 2019 is already showing, volatility is very strong. 

Synopsis:

• Macro and Credit - Looking for "safe havens"
• Final chart  -   Confidence has taken a knock

• Macro and Credit - Looking for "safe havens"

As we pointed out in our November conversation "Zollverein", when it comes to credit and macro, we tend to act like any behavioral psychologist, namely that we would rather focus on the "flows" than on the "stock". The S&P/LSTA US Leveraged Loan 100, which tracks the 100 largest loans in the broader Index managed to lose 2.54% over the month of December, still managing to post a positive return of 0.44% whereas US High Yield was down 2.26% for the year, close to US Investment Grade losses at 2.25%. Flow wise, U.S. High Yield funds ended up a bloody 2018 with a $3.94 billion withdrawal for the week ending on December 26. The full-year outflow amounts to a cool $35.3 billion, according to Lipper weekly reporters.

Back in September in our conversation "The Korsakoff syndrome", we pointed out towards a Wharton paper written by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein published in September and entitled "Mutual Fund Flows and Fluctuations in Credit and Business Cycles" (h/t Tracy Alloway for pointing this very interesting research paper on Twitter).

This paper points to using flows into junk bond mutual funds as a gauge of an overheated credit market to tell where we are in the credit cycle. In their paper they pointed out that investor portfolio choice towards high-yield corporate bond mutual funds is a strong predictor of all previously identified indicators of credit booms.

Why do we look at fund flows? There is as well another reason to our focus.

We like to look at fund flows from a total return perspective. This is a subject we also discussed in our January 2018 conversation "The Lindemann criterion":

"Fund flows have a tendency to follow total returns

Fund flows have a tendency to follow total returns, both on the way up and on the way down. When risk assets are performing well, investors do most of their saving in risky assets, and keep relatively little in cash. As the cycle matures, risk assets become more expensive and deposit rates rise, they do steadily more of their saving in safe assets. Finally as risk assets start to wobble they try and withdraw some money and do all of their saving in cash, precipitating a sell-off." - source Macronomics, January 2018

Of course, retail investors, being more feebler when it comes to their holding, no wonder they have been recently fleeing leveraged loans ETFs given the "liquidity" focus and attention it has been given by many pundits including former central bankers. As indicated by LeveragedLoan.com on the 1st of January, outflows in leveraged loans have been significant in recent weeks:

U.S loan funds saw yet another record outflow during the week ended Dec. 26, as retail investors withdrew $3.53 billion, according to Lipper weekly reporters. 

That’s the sixth straight substantial outflow, totaling a massive $13.5 billion, punctuating a staggering turnaround for the asset class. Before that withdrawal streak, U.S. loan funds and ETFs had seen some $10.3 billion of net inflows. For 2018, then, the final figure will be a net outflow of $3.1 billion, according to Lipper. 

The most recent activity brings the four-week trailing average to a $2.6 billion outflow. 

Loan funds accounted for $2.9 billion of this week’s outflow, while ETFs accounted for a $626 million outflow. The change due to market value was negative $746 million. 

With the withdrawal, loan fund assets have dropped to $90.7 billion, including $9.8 billion from ETFs, says Lipper. — Tim Cross" - source LeveragedLoans.com

When the trend is not your friend...The pressure on funds has been relentless and outflows significant in various asset classes as indicated by Bank of America Merrill Lynch in there Follow The Flow report from the 28th of December entitled "The worst year since the ’08 crisis":

"Closing the worst year since ’08 

Only a few days to go before the end of the year, and 2018 will be remembered as the worst year since 2008. Outflows dominated this year across high-yield, high-grade, equities and EM debt funds. The lack of yield across European fixed income assets and the lack of catalysts to reverse the outflows we have seen this year are painting a dim picture for 2019. With macro indicators continuing to point to more downside, we expect further widening in credit land. We also expect further beta underperformance amid challenging liquidity backdrop and rising idiosyncratic risks as the ECB QE is now over. 

Over the past week… 

High grade funds suffered another outflow, making this one the 20th week of outflows over the past 21 weeks. High yield funds recorded another outflow, the 13th in a row. Looking into the domicile breakdown, US-focused funds led the outflow trend, while Euro and Global-focused funds were slightly less impacted. 

Government bond funds recorded an inflow this week, the fourth in a row. Meanwhile,

Money Market funds recorded another large outflow. 

All in all, Fixed Income funds recorded another outflow, bringing this year’s outflow to

$102bn, a negative record for the asset class. 

European equity funds also continued to record outflows, making this week the 16th

consecutive week of outflows. During the past 42 weeks, European equity funds

experienced 41 weeks of outflows.

Global EM debt recorded another large outflow this week, the 12th in a row.
Commodity funds recorded another inflow. 

On the duration front, short-term and mid-term IG funds led the negative trend by far, while the long-end of the curve recorded another small inflow." - source Bank of America Merrill Lynch

We agree with Bank of America Merrill Lynch, cracks in credit markets have been significant and unless there is some stabilization, there will be additional pain inflicted to the high beta crowd hence the need to reach for quality.

As well throughout 2018, we mentioned rising dispersion in credit markets with investors becoming more discerning when it comes to selecting issuer profiles. We also touched on the increasing trend in large standard deviation moves in various asset classes typical in the late stage of an extended credit cycle which has been plagued by years of repressed volatility thanks to central banks meddling.

For instance, the latest Japanese yen's flash crash/rally highlighted how Mrs Watanabe aka Japanese retail investors, through Uridashi funds are still heavily invested in carry trades for extra yield such as the Turkish Lira, though in recent years they have drastically increased their allocation to the US dollar it seems as indicated by Bloomberg on the 3rd of January in their articled entitled "Flash-Crash’ Moves Hit Currency Markets":

"With Japan on a four-day holiday this week, traders said they struggled to handle a flood of sell orders with pricing erratic. Once the yen strengthened past 105.50 against the dollar, others were forced to cover their short yen positions, said traders who asked not to be identified as they aren’t permitted to speak publicly.

“It looks more like a liquidity event with the move happening in the gap between the New York handover to Asia,” said Damien Loh, chief investment officer of hedge fund Ensemble Capital Pte., in Singapore. “It was exacerbated by a Japan holiday and retail stops getting filled on the way down especially in yen crosses.”

As a result, the yen surged against every currency tracked by Bloomberg, and was up 1 percent against the dollar at 107.78 by 9:30 a.m. in London.

The haven asset has strengthened against all its major counterparts over the past 12 months as concerns over global economic growth mounted and stocks tumbled. It rose 2.7 percent against the dollar last year, the only G-10 currency to gain versus the greenback." - source Bloomberg

Given the intensity of the selling in December, with credit spread widening and gold surging as well in conjunction with the Japanese yen, no wonder investors are trigger happy when it comes to seeking refuge from the indiscriminate selling we have seen over the last quarter and in particular during the last month of the year.

The search for safe havens is well described also in Bloomberg's article from the 3rd of January entitled "In This Mess of a Market, Safe Havens Are Making a Comeback":

"The remarkable thing about recent yen performance may not be its almost 4 percent surge against the dollar on Thursday, but the fact the currency just clocked its best month in about two years.

That exact statistic also applies to gold, which in December notched the largest jump since January 2017. Both assets have continued to climb this year. Meanwhile, bonds of G-7 governments had their best December in a decade, according to a Bank of America Merrill Lynch index.

Put simply, traditional havens are back.

The same myriad of drivers bedeviling equity investors in 2019 is also sending them to safety. While the trade war is showing up in real-world data, it’s cropping up in company earnings too, as evidenced by Apple Inc.’s guidance cut on Wednesday. At the same time, Federal Reserve tightening is sapping liquidity and in the process reigniting volatility in markets. Idiosyncratic risks from the likes of Brexit and Italy’s budget squabble with the European Union are merely compounding the risk-off mood -- and adding fuel to the haven trade." - source Bloomberg

With earnings disappointment leading to more large standard deviations move in equities as indicated by Apple but by also Delta Airlines, with no real clear resolution as of yet in the trade war narrative between China and the United States, 2019 has started with even more volatility to say the least.

No wonder as indicated by Bloomberg's article above that the shiny little metal aka "gold" has been seen as well as a "safe haven" in times of acute turmoil:

"Going for Gold

Sentiment toward gold also brightened in mid-October, when money managers abandoned their record net-short position against the metal as the outlook for the dollar deteriorated.

Since then, investors have piled into exchange-traded funds backed by bullion, which have amassed 126 tons of metal worth $5.2 billion in 60 sessions -- the biggest increase over a comparable period in more than 18 months.

A paring of expectations for rate hikes has also contributed to demand, as gold typically falls during periods of monetary tightening because it’s a non-interest bearing asset.

“Gold is bid due to multiple headwinds” for the world economy, said Ole Hansen, the head of commodity strategy at Saxo Bank A/S by email. “Stocks, the dollar and bond yields are all down while the risk of further U.S. rate hikes has almost been removed.” - source Bloomberg

This is as all to do with investors looking at the flattening of the yield curve, weaker macro data and deceleration in global trade in conjunction with weaker earnings than expected and trying to figure out if the Fed will show some "Clemency" in similar fashion as Titus did in Mozart's opera.

We hinted a "put-call parity" strategy early 2014, eg long Gold/long US Treasuries as we argued in our conversation "The Departed", it has been working again nicely in December:

"If the policy compass is spinning and there’s no way to predict how governments will react, you don’t know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of governments, the option-value of both gold and bonds goes up."

Of course given the uncertainty surrounding the number of hikes and additional tightening from the Fed with the acute weakness in US equities, no wonder some pundits have been resorting to this "put-call parity" strategy.

Obviously, the sudden rise in US wages to 3.2% YoY in December, the fastest pace since April 2009 and with Nonfarm payrolls coming at 312K versus 177K expected, with a more dovish Fed on the wire as we type this very post, it seems that Fed chairman Jerome Powell has been listening to Stanley Druckenmiller and Kevin Warsh's take on the Fed's policy in the Wall Street Journal, hence the strong rebound seen in equities markets today. Not only have we seen the return of a Fed put, hence our "clemency" title analogy, but China has well has come to the rescue of decelerating growth with its cut of the required reserve ratio by 1% to release cash into the economy and support rapidly stalling growth. The RRR for banks will drop by 0.5% on January 15 and a further 0.5% on January 25, the PBOC said. Here comes the central banking "cavalry".

For credit markets, at least on the US side damages have already been done as seen in large outflows seen in recent weeks. What would clearly stabilize the situation we think, at least for US High Yield, would be a bounce in oil prices which would probably lessen the velocity in credit spread widening particularly in the high beta space of the CCCs bucket highly exposed to the energy sector.

Can the Fed restore "goldilocks"? A not too hot and not too cold economy? We wonder again, how much damage has been inflicted to US earnings due to the long lasting trade war narrative. Was the Apple large standard deviation move a wake-up call for the Fed?

One thing for sure is that the Huawei fight with the US administration is not about trade war, but mostly about "tech" war (and 5G). On that subject, we recently used the following chart in relation to the quantity of jobs created versus the quality as per the data from the BLS, this doesn't comprise the latest data release:

- graph source BLS - Macronomics

Back in January 2017 in our conversation "The Ultimatum game" we argued:

"The United States needs to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that matters in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again." - source Macronomics, January 2017 

Once again it isn't the quantity of job that matters, it's the quality of jobs. No matter how the Trump administration would like to play it, but productivity matters more than trade deficits. The lackluster most recent Purchasing Managers Index showed a fall in the reading from new orders in the US from 61 to 51, and China as well has been decelerating with its export orders falling below the 47 mark. This clearly shows that there is no clear winner from a trade war. 

Sure talks are about to start again between China and the United States but at this stage, as we stated above, it is all about damage assessment on earnings. 

Given the Fed has been on a hiking path in conjunction with its QT, as we stated in our conversation "Ballyhoo" in October 2018,  using a more real-time look at financial conditions points towards a higher velocity in the tightening trend of financial conditions, a case of "Reflexivity", being the theory that a two-way feedback loop exists in which investors' perceptions affect that environment, which in turn changes investor perceptions. On the subject of financial conditions we read with interest Nomura Special Report from the 28th of December entitled "Financial conditions turned restrictive for growth":

"Key Developments

• Our revised US financial conditions index (FCI) suggests financial conditions are now restrictive for growth (Figure 1).

•  Since the end of September our FCI has declined almost a full percentage point – from +0.7% to roughly -0.3% currently. The units of our FCI are the contribution of financial factors to growth over the next six months (see Refreshing US Financial Conditions Index for a complete explanation).

• After heightened volatility in October and November, US equity markets sold off sharply in December. So far this month the S&P 500 index is down 10.8% (through 27-Dec). Implied equity volatility remains high. The VIX index jumped sharply in December and remains elevated.
• Corporate spreads have widened notably since end-September. Investment grade options-adjusted spreads are now roughly at their long-term median, but they remain well below levels reached in late 2015 and early 2016.
• Business surveys suggest that credit is only modestly harder to get, at least for smaller businesses.
• The recent tightening of financial conditions is notable, in both equity and credit markets, and will probably affect how the FOMC sees the risks around its forecast.
• Potential external risks, such as Brexit, US-China trade negotiations and US fiscal policy debates in Congress, raise economic uncertainty and have a potential to tighten financial conditions further.
• At the margin, the recent tightening of financial conditions reduces the probability that FOMC will raise short-term interest rates again soon." - graph source Nomura.

This explains probably the "reflexivity" issue seen in the markets given the flattening of the yield curve with weaker macro data and decelerating global growth which created anxiety relating to the double impact of both rate hikes and QT on financial conditions.

As pointed out by Andreas Steno Larsen from Nordea on his twitter feed there is a direct relationship between US Financial Conditions and ISM Manufacturing PMI:

"We have been pretty explicit recently that ISM would drop FAST! ISM dropped from 59.3 to 54.1 in Dec.
Unfortunately more of the same is in store over the coming 3-4 months. Below 50 readings could be on the cards." - source Nordea, twitter

Obviously the recent dovish tone taken by Fed chairman Jerome Powell seems to have had the desired effect of tampering the velocity in the tightening.  

As pointed by Bloomberg in their article from the 3rd of January entitled "Jerome Powell Pledged Allegiance to Data and Some of It Looks Grim", the Fed is clearly in damage assessment mode when it comes to the data, regardless of the strong Nonfarm payroll print:

"Factory PainIf there’s one place where the data are souring decisively, it’s manufacturing. The Institute for Supply Management’s factory index dropped by the most since 2008 last month and touched a two-year low. While the ISM gauge remains in expansionary territory at 54.1, just 11 of 18 industries reported growth in December. That’s the fewest in two years.

Production problems are far-reaching. JPMorgan Chase &Co. and IHS Markit’s global manufacturing index fell in December to the lowest level since September 2016 as measures of orders and hiring weakened, data showed this week.

Trade uncertainty and concerns about global growth seem to be an important factor in the recent U.S. weakness: tariff worries have surfaced repeatedly in Fed surveys. Apple Inc. cut its revenue outlook this week for the first time in nearly two decades thanks to weaker demand in China.

Housing Wobbles 

Fed officials watch the housing market because it’s an interest-rate sensitive sector, and it’s been showing signs of cooling for months. That hasn’t abated since the Fed last met: the pending home sales index dropped 0.7 percent on a monthly basis in November, compared to an analyst expectation for a 1 percent gain. Home prices are still rising, but the latest S&P CoreLogic Case-Shiller index showed that gains continue to moderate.

Market Souring

While it’s not a real-economy measure, the Fed closely watches market volatility because it can feed through to consumer and business sentiment and the real economy. Stocks saw the worst December rout since the Great Depression and a few near-term Treasury security yields have crept above their longer-term counterparts since Powell’s December press conference, a sign that investors were pessimistic about the outlook for growth.

That’s enough to make Powell’s colleague in Texas, Dallas Fed President Robert Kaplan, argue for putting rate increases on hold for the first couple of quarters of 2019.

“This is a very critical time. We need to be very vigilant. We need to be on our toes. And I think patience is a critical tool we should be using during this period. We can get this right,’’ Kaplan told Bloomberg Television in an interview on Thursday." - source Bloomberg

The big question is, will this be enough to initiate a strong rebound in equities and a rally in all things "high beta" such as leveraged loans? 

When it comes to leveraged loans, as pointed out by Lisa Abramowicz from Bloomberg on her twitter feed, there has been already some "short covering" happening:

"BKLN, the biggest leveraged-loan ETF, is posting its best one-day rally in its eight-year history. Loans are suddenly benefiting from both a more positive outlook on the U.S. economy paired with benchmark rates that are rising again." - source Lisa Abramowicz - Bloomberg - twitter

Again what could cause a sustained rally? Clearly the "Clemency" of both the Fed and the PBOC can trigger some significant "short covering" also a positive agreement between the United States and China would alleviate some concerns, yet when it comes to the forward EPS optimism we criticized back in 2018 as not being warranted, it is all about how much "reflexivity" has been triggered and how much "confidence" has been shattered by the recent violent gyrations in various asset classes we think.

"The Clemency of Titus" aka Fed Chairman Jerome Powell is linked to the transmission mechanism between FOMC policy and the real economy. On this very subject we read with interest Wells Fargo's take from their note from the 3rd of January entitled "Time to Press Pause? Financial Conditions & the FOMC":

"Financial Conditions Have Tightened

Financial markets deteriorated sharply at the end of 2018. The S&P 500 fell more than 10% in the fourth quarter, while the yield on the 10-year Treasury security slid about 30 bps as investors flocked to safer assets. Given the forward-looking nature of markets, the tumult raised concerns about growth in the new year and was even seen as a reason the FOMC might hold off on its widely telegraphed rate hike in December. Chairman Powell stated numerous times in his post-meeting press conference that the Committee was not looking solely at financial markets, but broad financial conditions. So how have financial conditions—not just markets—evolved recently, and what does it mean for economic growth and the future path of FOMC policy?

For a wide-ranging view of financial conditions, we turn to the Chicago Fed’s National Financial Conditions Index (NFCI). The index includes 105 variables, capturing leverage, risk and credit conditions. Since the index is constructed to average zero over time (with a standard deviation of one), negative readings indicate historically loose financial conditions, while positive readings indicate historically tight conditions. Therefore, higher values of the index are indicative of tighter financial conditions.

The NFCI rose 14 bps over the fourth quarter of 2018 (Figure 1).

 - Source: Bloomberg LP, Federal Reserve Bank of Chicago and Wells Fargo Securities

The move was the largest quarterly increase since the start of 2016—a point at which the FOMC hit pause on rate hikes. Specifically, risk-related measures, like the VIX index and TED spread, have risen over the past few months. At the same time, indications of leverage, like weakening corporate debt issuance, have pointed to more restrictive financial conditions (Figure 2).

- Source: Bloomberg LP, Federal Reserve Bank of Chicago and Wells Fargo Securities

Credit conditions, which reflect the willingness to borrow and lend at prevailing prices, have been little changed. But the overall NFCI generally remains at a low level, indicating that general financial conditions are not overly restrictive at present.

Financial Conditions: The Transmission Channel between FOMC Policy and the Real Economy

Financial conditions per se are not an objective for the FOMC, but they are taken into account due to their indirect effects on the Fed’s two policy goals: “price stability” and “maximum employment.” The committee’s aim in tightening policy is to prevent the economy from overheating to the point that it risks significantly overshooting its inflation target, which it defines as PCE inflation of 2%. However, the FOMC’s primary policy tools, the fed funds rate and the balance sheet, have little direct effect on the Fed’s two policy objectives.

Instead, the FOMC’s tools affect the economy by influencing other interest rates and risk taking. In that way, financial conditions capture the transmission of FOMC policy to the real economy. Businesses and households will modify investment and saving plans depending on the relative ease or tightness of financial conditions. Tighter conditions, reflecting the availability and cost of credit, may reduce the ability and/or willingness to take on debt, which, all else equal, could weigh on growth in investment and consumption and thereby on the overall rate of real GDP growth. In contrast, easier conditions could stoke up growth in consumption and investment.

Behind the Starting Line after Three Years of FOMC Tightening

Given that financial conditions are influenced by FOMC policy, it is not unexpected to see broader financial conditions tighten as the Fed normalizes policy. In other words, tighter financial conditions are an anticipated byproduct of FOMC rate hikes. But monetary policy decisions and broad financial conditions do not always move in tandem. Despite the FOMC raising its target range for the fed funds rate 225 bps since late 2015, financial conditions as measured by the NFCI have eased on net over the period (Figure 3).

 - Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities

The easing has primarily come in terms of credit, with, for example, corporate bond spreads narrower and bank lending standards looser. The overall easing in financial conditions since late 2015 stands in contrast to the previous two tightening cycles in which the FOMC raised rates by the same amount. As noted previously, general financial conditions do not appear to be overly restrictive at present.

With financial conditions still easy relative to when the Fed first began to normalize policy, does that mean there is more tightening in store? In each of the previous six rate-hiking cycles, the FOMC did not stop until financial conditions had tightened on net (Figure 4).

  - Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities

This historical record suggests that the FOMC may very well have a few more rate hikes to go in this cycle, at least at first glance.

Does the FOMC Need to See Financial Conditions Tighten Further?

The traditional NFCI does not take into account underlying economic conditions. All else equal, it makes sense for investors to take on more risk, for households to take on more debt and for lenders to ease standards in an improving economic environment. As a result, financial conditions and economic conditions are often closely correlated. Therefore, it is not unusual to see financial conditions ease, at least for a time being, at the same time the FOMC is raising rates—both are responding to a stronger economy.

To isolate financial conditions only, the Chicago Fed also calculates an Adjusted National Financial Conditions Index (ANFCI). The ANFCI controls for the macroeconomic environment, and thus it is more telling in regard to how underlying financial conditions have evolved. By this measure, financial conditions have tightened more in recent months than implied by the NFCI alone (Figure 5).

  - Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities

Specifically, the ANFCI has increased about 20 bps since late September, which is about twice as much as the increase in the NCFI. Although the ANFCI remains low in a historic context, the rise in the index implies that financial conditions are a bit tighter in total than when the Fed first began raising rates in late 2015 (Figure 6).

 - Source: Federal Reserve Bank of Chicago, Federal Reserve Board and Wells Fargo Securities

The degree to which financial conditions have tightened over a rate-hike cycle helps quantify how far—or short—the FOMC has come. Yet there is no set amount by which financial conditions need  to tighten, or a threshold to cross, before the FOMC stops raising rates. If the economy is showing few signs of overheating, looser financial conditions relative to the start of a tightening cycle are not necessarily a problem. The same can be said for an economy where growth is slowing back toward its longer-run trend, as is the case today.

How financial conditions impact the stability of the overall financial system may, however, be of concern. If a prolonged period of loose financial conditions stokes instability via greater risk taking, more leverage and questionable credit, then those factors may affect policymaking. That said, the primary means of addressing financial instability are likely to be targeted regulatory (macro-prudential) policies by the Federal Reserve and other federal banking agencies rather than the blunter tool of changes in interest rates by the FOMC. At present, the Fed generally does not seem to be unduly concerned with financial stability. The Federal Reserve Board’s inaugural Financial Stability Report released in November found that while valuations are elevated, private sector credit risks are moderate and leverage and funding risks are low.

Moreover, the cumulative amount of tightening in financial conditions may not be as much of an issue as the speed. Over the past month, the financial conditions indices rose faster than at any time since the start of 2016 (Figure 7).

Given that it takes time for financial conditions to effect the real economy, the FOMC could perceivably hold off on subsequent rate hikes in the near term as it waits to see how financial conditions have affected growth prospects.

Conclusion: The FOMC Might Revisit the Pause Button

The last time financial conditions tightened as sharply as this past December was at the start of 2016. Back then, the FOMC had just raised the fed funds target rate for the first time since the crisis. However, signs of slower growth in China caused volatility in financial markets to spike and overall financial conditions tightened. Following its initial rate hike in December 2015, the FOMC subsequently remained on hold until December 2016.

Our most recent forecast, which was compiled in early December, looks for two 25 bps rate hikes in 2019, first in March and again in September. But we readily acknowledge that the risks are skewed to a longer pause in the first half of the year than we thought just a month ago. Overall financial conditions do not appear to be overly restrictive at present, but they clearly have tightened in recent weeks. Consequently, the FOMC may decide that a period of wait-and-see is again appropriate, especially with the fed funds target rate already close to many committee members’ estimates of “neutral” and with inflation showing few signs of significantly exceeding the Fed’s target of 2%. We will be watching incoming data and making changes to our Fed call, as appropriate." - source Wells Fargo

Sure "Titus" might have shown some "late" clemency and maybe just re-initiated the infamous/famous "put" given the recent rout in various asset classes, but it remain to be seen if it too late to re-ignite the "animal spirits" and trigger a sustained rally given that a lot of damages have already been inflicted on the back as well of more surprises to be seen on more "earnings surprises à la Apple or Delta Airlines. We continue to advocate playing defense and use the rally to reduce your beta exposure in search of quality. It doesn't matter how long the Fed's clemency is going to last, we think we are clearly in the final innings of this extended credit cycle and you probably should focus more your attention on capital preservation than capital appreciation. 

If indeed the Fed is data dependent (or more likely S&P dependent...), then obviously, the "Clemency of Titus" is somewhat warranted as per our final chart below showing that for global CFOs, they have been less optimistic thanks to trade war fatigue obviously. 

• Final chart  -   Confidence has taken a knock

If success is a mind game, so is confidence and in the case of CFOs as per our final chart from Bank of America Merrill Lynch's The Inquirer note from the 31st of December entitled "Planet Earth to Policymakers - Please Reflate", then there is more downside to come when it comes to Global PMIs:

The view of asset markets and global CFOs is in sync – global growth is now in a broad, deep and persistent slowdown. The IMF, however, sees global real GDP growth going from 3.73% in 2018 to 3.65% in 2019, a second decimal slowdown. Policymakers are in the same stable boat, which is vulnerable to capsizing. The breadth of OECD leading indicators, which was near historical highs at the start of the year, has weakened considerably. In October 2018, only 10% of countries saw YoY rises in the OECD leading indicator vs. 71% in January 2018. In January 2018, 46 of 47 global equity markets were above their 200-day moving averages, now only 7 of 47 are. The world monetary base is contracting 0.5% YoY, and likely to shrink 4.6% by December 2019, unprecedented in 37 years.

The bottom line: Financial markets and CFOs think the world economy is in real trouble. Policymakers are oblivious to this scenario. One of them is going to be wrong. Past history suggests, the policymakers. The science experiment of Quantitative Tightening might be halted, the Chinese credit impulse is still in free-fall and might need to be revived a lot more dramatically, and global fiscal easing could be a lot more muscular. Those are 2019’s likely surprises. If this happens, Asia and EM equities could be in for massive gains. Stay tuned." - source Bank of America Merrill Lynch

Could the central bank cavalry come to the rescue of global equities? Or is too little too late? We wonder....

"If there is something to pardon in everything, there is also something to condemn." -  Friedrich Nietzsche

Stay tuned! 

Macro and Credit - Poker tilt

"If you're playing a poker game and you look around the table and can't tell who the sucker is, it's you." - Paul Newman

Looking at the tentative rebound in gold prices thanks to the fall of the US dollar in conjunction with some respite for some selected Emerging Markets (EM) as well as the escalating tensions between Italy and the European Commission on migrants with pressure building up on the ECB's "Le Chiffre" aka Mario Draghi, when it came to selecting our title analogy, we decided to go yet again for a poker reference. As we stated in our previous conversation, it remains to be seen who ultimately is going to be the ongoing buyer of Italian government bonds with plans for a reduction in QE in Europe. In the game of poker, tilt is a term used for the state of mental or emotional confusion or frustration in which a player adopts a less than optimal strategy usually resulting in the player becoming over-aggressive (such as Turkey's Erdogan calls on Turks to ignore forex developments and to sell their gold and dollars to support their crumbling lira). Placing an opponent on tilt or dealing with being on tilt oneself is an important aspect of poker. It is a relatively frequent occurrence due to frustration, animosity against other players, or simply bad luck. Experienced players recommend learning to recognize that one is experiencing tilt and avoid allowing it to influence one’s play. In our October 2015 conversation we praised both Le Chiffre and Mario Draghi. Both of them share the same trait, both are poker prodigies hence our title analogy at the time. We wonder if President Donald Trump could be one as well given the pressure he has applied in his various negotiations on numerous issues including trade tariffs. In this current game of high stake poker, particularly with China, one might wonder if Trump is not trying to upset the mental equilibrium of his adversaries which is essential for optimal poker judgment (NAFTA being the most recent example). Though many advanced players (after logging thousands of table-hours) claim to have outgrown poker "tilt" and frustration, many other poker professionals admit it is still a "leak" in their game but we ramble again.

In this week's conversation, we would like to look at the potential for tactical rebound for EM, as we move towards the important US midterm elections.

Synopsis:

• Macro and Credit - Could we see a tactical bounce in EM?
• Final chart - US credit growth still on cruise control

• Macro and Credit -  Could we see a tactical bounce in EM?

Whereas the heat was on during the summer for various Emerging Markets thanks to murderous rampage of "Mack the Knife" (King Dollar + positive real US interest rates), we recently touted MDGA aka Make Duration Great Again. Recently, not only have we seen some small yield compression in the long end of the US yield curve, but as well the dollar has slowed down and fallen a tad ensuring a small bounce in gold prices as well. Also, credit markets in particular US Investment Grade credit have had more favorable returns in recent months. One can therefore wonder, with the latest NAFTA discussions, if indeed some sort of tactical rally for EM is in the cards on the road to the important midterm US elections.

On this subject we read with interest Bank of America Merrill Lynch's take in their Global Liquid Markets Weekly note from the 27th of August entitled "EM climbs out of Jackson hole":

"US midterms a winner for EM

After Jackson Hole the focus this week shifts to EU and US inflation, but the real story for the months ahead will more likely be the US midterms. We think they are about to turn from a bearish to a bullish theme for EM through positive news on trade and a peak in the USD. So we expect a post-summer EM rally – though a tactical one before global risk assets, this time including the US, come under pressure in 2019.

Midterms trigger post-summer rally

Since our year ahead report (“Taxing EM”) we have been looking at EM through the lens of the midterms – now about to turn from a negative to a positive factor. The fiscal stimulus package and trade tensions have been closely linked to the approaching elections and have weighed on EM so far. Trade wars have become by far the most feared risk, according to our monthly investor survey. Now, however, David Woo expects an imminent NAFTA deal and some progress with China, as the polls suggest that the US administration has a strong incentive to present good news on trade. Importantly, we expect the next round of China tariffs scheduled for Sep 6 to lapse as they would be too painful for the US consumer and the agricultural heartland (via China retaliation).

A glass half full – just about

Predictably, EM sold off during our usual August break – as in 8 of the last 10 ones: the 10-year average EMFX return in August is the 2nd worst after November. However, the volatility occurred on low volumes, and neither external nor local debt saw fund outflows over the summer.

The current level of our EMFX carry sentiment indicator implied positive returns in EM carry in 56% of the subsequent 4-week periods since 2004: ie, a glass half full but hardly convincing enough for a big “Back to School” party. 

Softer USD = EM outperformance

Time and again a weaker USD dominates any other EM driver, whether global or local. Chart 2 shows this on the basis of monthly correlations of EM returns with the USD and other potential drivers.

This has also been the case during periods of Fed tightening – as long as other factors have managed to hold the USD down. In fact, monthly EM returns have surprisingly been negatively correlated with the G3 central bank balance sheet.

Indeed, our G10 team now sees the USD rally this year close to its peak. (1) Trade war fears seem to have become USD positive lately, so their easing should be USD negative. (2) The US-EU data surprise differential seems to have peaked too for now. (3) Positioning in US vs rest-of-the-world assets is back to historical highs. Short term, Italy budget fears could still weigh on EUR/USD, but for next year our team targets 1.20.

QT doesn’t matter … until US HY cracks

Quantitative tightening per se isn’t EM bearish: it still comes down to its impact on the USD. If the USD really weakens into 2019, a repeat of the experience of the last cycle is likely: US high yield peaked in mid-2007, then it moved sideways for one year while EM debt continued to perform. However, when US credit finally entered an outright bear market mid-2008, EM wasn’t spared either, and risk-off became USD bullish (Chart 2). A key difference to ‘07 is that EM is unlikely to benefit from rating upgrades (Chart 3).

Consensus says EM fundamentals are still decent: we don't disagree on this specifically, but we do think that the rate of change of these fundamentals is negative, risks are to the downside and spreads are fair rather than cheap even after the latest sell-off.

Best local value: Indo, Mex, SoAf, Thai

Summing up, we see a post-summer rally in EM that benefits local more than external debt as its main trigger would be a weaker USD and less trade fears: it may last for a while, but by 2019 we expect EM debt to crack when US high yield does. To position for a tactical rally in September in Asia we like long THB FX and Indonesia local 10yr bonds. We have turned from bearish to neutral CNY, and local front-end bonds are starting to look attractive after the rebound higher in yields in the past two weeks.

In LatAm we like short EUR/MXN on a better global backdrop and NAFTA. In EEMEA South Africa has the best risk/reward in FX and rates given its high beta to China and EUR/USD. Valuations are good based on the real yield; three hikes priced in; and ZAR near our fair value estimate. EUR/CZK has downside if EUR/USD goes higher.

In contrast we don’t find risk/reward compelling in Russia and Turkey. In Russia we have argued for a while that sovereign sanctions risks were underestimated. We just closed our shorts but want to wait for a sell-off on an actual passing of the sanctions bill pre-midterms before buying ahead of the likely oil-bullish Iran sanctions in November. In Turkey real yields are finally in line with the peers, even accounting for the imminent CPI spike, but they are not high enough to compensate for the political noise (Chart 4).

Long term, sovereign external debt looks cheap with an implied CCC rating, but short-term investors have to brace for further volatility spikes driven by the exchange rate." - source Bank of America Merrill Lynch

Flow wise, this summer has been a bloodbath for many asset classes with no one being spared. These funds outflows have continued recently according to Bank of America Merrill Lynch which is somewhat revealing as well the magnet appeal of the US dollar as per their Follow The Flow Report from the 24th of August entitled "IG, HY, Equities and EM debt all down for the year":

"Outflows continue from IG, HY, govies, EM and equities

It seems that investors have nowhere to hide. Almost all the risk assets we follow recorded outflows last week. We saw outflows from IG, HY, Govies and EM debt; same in equities. Higher risk assets’ volatility, EM FX sell offs, trade wars and Italian political risks have instigated a risk off trend in flows across risk assets.

Rate differentials across the globe are shifting flows away from low yielding and risky markets. Note the significant shift of assets out of euro credit to dollar credit over the past months on the back of dollar strength.

Over the past week…

High grade funds recorded another outflow last week; but arguably more moderate to that of last week’s. High yield funds were hit again by outflows. Looking into the domicile breakdown, European-focused funds recorded the lion’s share of outflows, while outflows from global and US-focused funds were more moderate.

Government bond funds recorded another outflow last week, albeit more moderate to the outflow suffered a week ago. All in all, Fixed Income funds recorded another sizable outflow last week.

European equity funds continued to record outflows for the 24th consecutive week. $56bn has left the asset class over that period.

Chart 1: IG, HY, Equities and EM debt all down YTD (cumulative flows, $mn)

Global EM debt funds recorded another outflow last week, while the magnitude of the outflow more than tripled w-o-w. Commodity funds recorded an outflow.

On the duration front, reach for “safety” prevailed. Small inflows into IG short-term funds, were more than offset by outflows in the belly and the back-end of the curve. Mid-term funds suffered the most last week, with outflows increasing steadily over the course of the past three weeks." - source Bank of America Merrill Lynch

 The US have attracted inflows particularly given cash is becoming more and more attractive on a relative basis and for investors seeking some sort of safe haven in the context of EM gyrations. What is interesting to note as of late is the clear deceleration in some macro outputs in the US such as Existing home sales declining 0.7% to 5.34 million unit pace in July, new home sales falling as well thanks to the issue of "affordability" in conjunction with the softness in Durable goods orders slipping 1.7% in July. This is in contrast to the latest FOMC minutes showing Fed members clearly in the strong economic outlook camp. This is of course ensuring another hike in September.

Yet, some positioning in US bonds remains elevated we think, and if indeed some pundits get poker tilted, then there is a probability of seeing some sizable strong short covering in very short order. Same apply to some shorts in the gold mining space, which have been relentlessly hit by the fall in gold prices but it seems we are not there yet. Returning on the "contentious" issue argued by many on the stretched positioning on US Treasury notes, we read with interest Bank of America Merrill Lynch's take in their Global Liquid Markets Weekly note from the 27th of August entitled "EM climbs out of Jackson hole":

"Extreme positioning elevates risk of bond rally

While we continue to target 10y rates at 3.25% for the end of the year, the ongoing buildup in non-commercial short positioning in the Treasury futures complex does not bode well for our outlook. We studied the connection between positioning – as defined by the Commitments of Traders report published by the Commodity Futures Trading Commission – and subsequent changes in 10y rates and found a relatively high occurrence of 10y rallies after non-commercial positioning hit extreme short levels.

While positioning is just one piece of the duration puzzle, the ongoing trade negotiations and increased political headline risk moving into the midterm elections are also not favorable to our bearish rates outlook. On the flip side, however, we still view the minimal Fed pricing – just 70bp of hikes priced between now and the end of 2019 – as perhaps the most compelling reason to remain in the bearish camp for rates and in the flattening camp for the curve.

Chart 5 shows the net position of traders classified as non-commercial, or speculative, across the curve.

This classification is the residual of the commercial designation, which the CFTC defines as traders who use futures to hedge business risks. We also looked at the newer CFTC designations: leveraged, asset managers, dealers, and other, but found the strongest results within the original data set.

The net spec positions shown in Chart 5 are defined as spec longs minus spec shorts, where the units are 1000s of contracts. This is a measure of positioning within the spec category, and by definition will be offset by positioning in the commercial category (Chart 6).

As a result, a study of non-commercial positioning should show mirror image results in the commercial data, which is what we found.

To each week of reported data we attach a simple z-score of the net position by looking at the current value versus the average over the past 2.5 years. We looked at both raw net positioning and net positioning relative to total open interest for the contract. The results were very similar. The data is reported on Fridays and corresponds to the Tuesday of that week. We tracked the 3-month change in 10y rates starting on the Tuesday of each week.

Go commercial

To summarize: when positioning becomes highly unbalanced between commercial and non-commercial traders, ie when a large net spec positon or equivalently a large net commercial position develops, the market tends to move in favor of the commercial positions and against the non-commercials over the following 3 months. Table 1 summarizes our results for TY contracts. The results for US contracts were similar.

There are 3 key takeaways:

1. When positioning becomes unbalanced, there is a higher occurrence of the 10y rate moving unfavorably for the spec positions. This is based on a comparison of how frequently 10y rates rise or fall over a 3-month horizon in the entire sample versus how frequently rates rise or fall when accounting for positioning. As an example, when the z-score of net positioning is lower than -1 (positioning is below its average by at least one standard deviation), we found the 10y rates rallied 63% of the time versus a full-sample rally frequency of 52%. Similarly, when looking at the net commercial position, we found that a net long position beyond 1 standard deviation resulted in a rally frequency of 60%.
2. The magnitude of 10y rate moves following position buildups increases as the position size becomes more extreme. For example, when short spec positioning is below average (z < 0), the 3-month rate rally averaged 6bp. When z < -1, the average rally was 11bp, and when z < -1.5, the average rally was 14bp. A similar type of tiering was seen for bond market selloffs following buildups of long spec positions.
3. Positioning typically gets partially covered in the 3 months following an extreme buildup. When non-commercial positions get short and commercials get long, the data show that on average, these positions partially unwind over the next 3 months. This position squaring shows a greater magnitude as position imbalances increase. For example, when net specs measure z < 0, the following 3-month cover is on average 28k contracts. But when spec shorts are z < -1, the 3-month average covering move is closer to +50k contracts. This provides evidence that the rate moves are exacerbated by position squaring, both on the spec side and the commercial side.

The latest data point was observed on 17 August for positioning as of 14 August and we will get an update this afternoon for positioning as of 21 August. The latest z-score for TY specs was -2.2, which occurred in only 4% of the days we looked at back to early 2003. The one bright side for bond bears, however, is that 10y rates have already rallied about 8bp since 14 August. But if the z-score remains high, it would not increase confidence in our 3.25% target for year-end.

- source Bank of America Merrill Lynch

One would therefore wonder if it's time to put back on your MDGA (Make Duration Great Again) hat on given their is a higher probability that the speculators at the table might at some point in the near future get poker tilted and start short covering massively should the macro picture deteriorates sensibly over the course of the coming months due to internal or geopolitical factors coming into play (the known unknowns). The key to putting on your MDGA will be the direction of the US dollar in the coming weeks/months. Right now it's still "risk-on" and we continue to favor a US overweight over the rest of the world, yet there could be some relief rally continuing for some oversold EM countries in the mix.

Returning to our poker analogy, us being fond of game theory, we read with interest Bank of America Merrill Lynch's Global Economic Weekly note from the 24th of August entitled "What good is a poker face if you aren't playing poker?":

"What good is a poker face if you aren’t playing poker?Last week we discussed the wide array of risks that the markets will have to navigate in the coming months. This week we focus on a common theme in what we view as the three headline risks on the horizon: the US-China trade war, the Iran oil sanctions and the risks emanating from Europe (Brexit and Italexit). These are all conflicts that live at the intersection of economics and politics. Political economists and other commentators have sometimes depicted such conflicts as games of poker or “chicken,” in which both sides use confrontational rhetoric to signal a position of strength, in the hope that the other side will capitulate. Here we argue:

• The “game of chicken” view of political conflict assumes a zero-sum outcome: serious accidents are avoided.
• But aggressive rhetoric increases the political cost of backing down. Mutual escalation might be the only feasible outcome.
• In other words there is a risk of stumbling into a “prisoner’s dilemma,” in which both sides incur serious economic costs.

The devil is in the details

The “game of chicken” and the “prisoner’s dilemma” are two popular game-theoretic frameworks that are often used to describe real-world situations. They are similar in many ways. Using terminology from our previous work, in both settings, two countries (or any two sides in a conflict) must choose whether to escalate or de-escalate a potential conflict. Mutual de-escalation preserves the status quo but mutual escalation results in a “lose-lose” scenario that leaves both sides worse off than they were under the status quo. And in both settings, a country “wins” when it escalates the conflict but the other country de-escalates.

There is only one real difference between a game of chicken and a prisoner’s dilemma, but it has important consequences. The framework represented in Chart 1 becomes a game of chicken when the unknown variable c, which is the cost of capitulation (losing when the other side wins), is not very large (c inferiror to 10). In this case, if one country is certain to escalate the conflict, the other prefers to de-escalate. That is, countries would rather “hand the other side a win” than pay the price of mutual escalation. As a result the
game of chicken typically has a relatively benign outcome or “Nash equilibrium.” One
country wins and the other loses, but barring some miscalculation, the mutually-painful scenario is avoided.

By contrast, Chart 1 represents a prisoner’s dilemma if the cost of “letting” the other side win is so high (c superior to 10) that both sides prefer the lose-lose outcome instead. Since they both have incentive to escalate the conflict regardless of whether the other side escalates or de-escalates, the only possible result is mutual escalation.

No one wants to be chicken

We think this simple framework provides broad lessons for many of the political risks facing the global economy. The first is about rhetoric. In a game of chicken, strong rhetoric is helpful in signaling commitment to a confrontational stance. Examples include:

• The Trump administration’s threat to put tariffs on another $200bn in imports from China and raise the tariff rate to 25% (from 10%), even though the prices of consumer goods such as electronics will likely increase.
• China’s unwillingness to compromise thus far, even though economic activity appears to have slowed slightly because of the trade war, and the Shanghai Composite Index is down almost 20% year-to-date. China has responded to the latest US threats by promising to retaliate with tariffs on $60bn of US goods.
• The strong statements that have been made in the US-Iran conflict. For example, President Rouhani recently said that “war with Iran is the mother of all wars,” even though military conflict is not a realistic possibility.
• The UK government’s claims soon after the Brexit vote that it had a strong negotiating hand. More recently, Brexiters’ insistence on a clean break from the EU, even though a ‘hard’ Brexit would be economically very damaging for the UK.
• The euroskeptic Italian government’s proposals for aggressive fiscal expansion, even though it would run counter to EU rules, which call for a reduction in the structural deficit. Chiara Angeloni and Gilles Moec expect the 2019 Italian budget to target a deficit of less than 2% of GDP. This would be modest relative to campaign promises but would still be about double the previous government’s 2019 target.

In each case we think the goal is to make the other side blink in the face of aggression. However, the risk is that these conflicts will morph into prisoner’s dilemmas. How so?

First, very strong rhetoric increases both sides’ political cost from backing down. In our view, China would be willing to make some compromises to the US, including increasing its purchases of US agricultural and energy products, and taking stronger measures to protect the intellectual property of US firms operating in China. And in a game of chicken, given China’s exposure to US demand, such compromises would be in China’s economic interests.

But it is difficult for China to make concessions when the US is dialing up the rhetoric. The Trump Administration’s chief economic adviser Larry Kudlow recently stated on TV that China is a “lousy investment” and is “in a weak economic position,” which is “not a good place for them to be vis-à-vis the trade negotiations.” This sort of language makes compromise tantamount to an admission of weakness. Little wonder then that President Xi’s confrontational stance against the US remains popular in China.

Similarly, it is probably not in the US’ economic interests to enforce its sanctions on Iranian oil to the strictest degree possible. As we argued last week, driving supply out of Iran to zero would likely push oil prices above $100/barrel, which would be a headwind to growth. But the threats out of Iran raise the political costs of reconciliation and make the US-Iran conflict more like a prisoner’s dilemma. A mutually—and in this case globally—painful outcome could be in the offing.

The second, related concern is that strong rhetoric increases one’s own costs from backing down. Over the course of the Brexit negotiations, it has become increasingly clear that the EU will drive a hard bargain because conserving the single market is more valuable than undermining it to keep the UK in the EU. Moreover, the EU committed itself to a tough stance by publishing the EU Council’s negotiation mandate before the start of the negotiations. The mandate is all but impossible to change because all 27 countries and the European Parliament would have to unanimously agree to do so.

Some UK leaders, including Prime Minister May, seem to have realized that the UK is in a position where it must compromise, not least because of the looming March 29, 2019 deadline. This may be why they presented a Brexit deal last month that was economically negative for the UK—free trade in goods, the EU’s comparative advantage, but not in services, the UK’s comparative advantage—but was still economically better than no deal.

However, the proposal sparked rebellion among the Brexiters in her party, with threats to bring down the government. May’s “Chequers deal” proposal now appears to be in serious trouble. Brexiters have made the overly-ambitious promise to leave the EU but somehow continue to trade frictionlessly with the region. Now their political credibility concerns may be raising the risk of a no-deal Brexit.

Is talk cheap?

It might be possible to win a game of chicken by “bluffing,” i.e., convincing the other side that you are likely to escalate the conflict even if that is not the case. This is not an ideal outcome for the other side but at least there is room for compromise while avoiding an accident. In a prisoner’s dilemma, however, there is no value in bluffing or posturing because the other side will always call your bluff.

The conflict between the Italian government and the EU is in its early stages. It is possible that Italy will be able to elicit some compromise out of Brussels on budget targets and immigration by essentially bluffing on its willingness to leave the Eurozone. But to achieve this outcome, Italian leaders will have to reduce the political costs to the EU from making concessions. There should be room to sell any deal as a compromise rather than a repudiation of the EU.

Similar lessons can be applied to the trade war, Iran and Brexit. In each case there is room for compromise and the question is how much each side will give up. To a degree, strong statements can help because they might push the other side to make more concessions. But if the rhetoric becomes too strong, the only deal available is no deal at all." - source Bank of America Merrill Lynch

The questions remain whether the Trump administration will need to tilting or not with their current skills. The jury is still out there when it comes to trade negotiations taking place. Overall markets remain highly supportive, particularly in the US even if some weaknesses have shown up as of late in some macro data, although the Fed is tightening, lending surveys still point out towards economic expansion, even if we are late in this credit cycle.

• Final chart - US credit growth still on cruise control

The most predictive variable for default rates remains credit availability. The latest Senior Loan Officer Opinion Surveys (SLOOs) point that credit remains plentiful still. SLOOS report does a much better job of estimating defaults when they are being driven by a systemic factor, such as a turn in business cycle or an all-encompassing macro event. Our final chart comes from Deutsche Bank Strategy Update note from the 28th of August entitled "The bearish bias returns" and shows that the latest Fed SLOOs remain supportive of domestic demand (yes US consumer are using their credit cards...):

"Data supportive of higher rates, political risk remains a headwind

Since early August, the data has remained supportive of higher rates. In the US, the bank lending survey has improved and is consistent with domestic demand remaining comfortably above potential (left graph below). GDP trackers for Q3 are consistent with ~3% growth (right graph below), which is broadly in line with our economists' forecast.

It is worth noting that capex has upside relative to a series of indicators (graph below).

This could compensate a negative impact from trade wars on investment. On the inflation front, the latest data was generally encouraging. Our economists continue to expect core PCE and core CPI at 2.3% and 2.5% at the end of next year, which is broadly consistent with leading indicators such as the ISM or the NY Fed Inflation Gauge (graph below).

The recent USD strength could be a concern for the medium term inflation outlook. However, (a) it has been relatively modest so far and (b) given the lead/lags it should become a headwind in H2-19 at the earliest." - source Deutsche Bank

If indeed over the coming months inflation does indeed accelerates thanks to transfer of rising costs from the producers to the consumers, then, we think Jerome Powell the other poker player at the Fed will not be bluffing when it comes to hiking more aggressively and this might still catch quite a few pundits off guard.

"When people use the word 'science,' it's often a tell, like in poker, that you're bluffing." -  Peter Thiel

Stay tuned !